The VA Drug Pricing Model: What Senators Should Know

The Senate will soon debate Medicare drug price "negotiation,"
or repeal of the "non-interference" clause of the Medicare
Modernization Act of 2003, which prevents government interference
in the negotiations between drug companies and the private plans
that market drug benefits in Medicare. During the recent House
debate on price negotiation, several Members cited the experience
of the Veterans Administration (VA), arguing that the VA model of
drug price negotiation could work in the larger Medicare program.
But the VA does not simply negotiate prices; rather, it
fixes prices and then reduces the range of drugs offered to
enrollees. Not only would the VA pricing model reap little savings
in Medicare, but it would also fail to meet the needs of
beneficiaries.

How the VA Fixes Drug Prices and
Restricts Access

Unlike Medicare, in which beneficiaries can choose drug plans,
each with its own formulary, the VA offers no choice. Serving as
the sole purchaser of drugs, the VA maintains a single national
formulary that physicians must follow.

The VA formulary is created through access restrictions on
drugs. For drugs to be covered on the formulary, their makers must
list all of their drugs on the Federal Supply Schedule (FSS) for
federal purchasers at the price given to the most-favored
nonfederal customer under comparable terms and conditions.[1] Additionally,
drug makers must offer the VA a price lower than a statutory
federal price ceiling (FPC), which mandates a discount of at least
24 percent off the non-federal average manufacturer price (NFAMP),
with a rebate if price increases exceed inflation.[2]

If drug makers do not comply with these terms, all of their
drugs are excluded from federal programs except the market-based
Federal Employees' Health Benefits Plan (FEHBP) and Medicare Part
D.[3] The VA's
discounts are mandated by law, and drug makers capitulate primarily
because they want to maintain access to Medicaid, which comprises
about 20 percent of the drug market.[4]

Beyond this regulatory pricing process, the VA sometimes obtains
larger discounts by committing to purchase and use only certain
drugs, thereby denying other drug makers access to the formulary
and the VA market.[5] In these cases, drug makers tend to concede
for three reasons: the VA system represents a small share of their
market (usually 2 percent to 3 percent); doctors who might
prescribe their drugs in the future often train in the VA system;
and the VA's "closed" health system means there is little risk that
the VA's discounted drugs will find their way to the private market
and undercut broader pricing strategies.[6] Facing substantial fixed
costs and relatively low production costs, drug makers are usually
willing to accept below-market prices rather than not sell at all
when a market is small enough that the loss in marginal profits
will not significantly reduce overall profitability.

While the VA's pricing practices do not consist of price-fixing
mechanisms alone, they are not "negotiation" either. The VA does
not use its buying power to negotiate with drug companies for lower
prices. Instead, the government, acting through the VA, uses its
power to deny manufacturers market access as a way to extort lower
prices. But these lower prices come at the expense of fewer drugs
for patients.

Blocked Drugs: The VA Formulary

The restrictiveness of the VA drug formulary is one of its least
attractive features, particularly as a model for the seniors and
disabled individuals in Medicare. Recently, the Lewin Group, a
prominent consultancy that models health policy proposals, compared
the formularies of the VA, the most popular FEHBP plan, and the two
Medicare Part D plans with the highest enrollments, focusing on the
300 drugs most prescribed to senior citizens. Lewin found that, of
the 300 drugs, 106 (35 percent) are not included in the VA
formulary, compared to 16 (5 percent) in the FEHBP formulary, and
18 (6 percent) and 19 (6 percent) in the Part D plan formularies.[7]

A separate analysis by Alain Enthoven and Kyna Fong of Stanford
University[8]
explained that, overall, less than one third of the 4,300 drugs
available to Medicare beneficiaries are on the VA national
formulary.[9] A
closer look at the VA formulary reveals that new and innovative
drugs, which tend to be more costly, are often excluded. According
to a study conducted by Columbia University Professor Frank
Lichtenberg, only 38 percent of the drugs approved by the FDA in
the 1990s and 19 percent of the drugs approved since 2000 are on
the VA national formulary.[10]

Economically, because the VA market is relatively small and
mostly fails to cover expensive breakthrough drugs, government
price fixing and further access restrictions can achieve savings in
drug prices. Politically, the VA is able to restrict access because
many veterans have other public or private insurance that, in
effect, supplements the VA coverage.[11] Recent estimates show that
up to 40 percent of Medicare eligible VA enrollees are now
accessing drugs through Medicare part D.[12] While the VA model may
work well for the VA given its circumstances, it could not easily
be applied to Medicare.

Imposing the VA Model on Medicare

The size of any market can be an important determinant of price,
particularly if market share is moved toward some drugs and away
from others. However, there is a point at which size can be a major
impediment to obtaining a below-market price, even if drug makers
are routinely restricted or denied access to the market. Imposing a
single, restrictive formulary would be much tougher to implement in
Medicare, which is 20 times the size of the VA and represents 40
percent of the pharmaceutical market.[13] Because Medicare is so
large and expected to rapidly grow, an attempt to impose the VA
pricing model on Medicare would undoubtedly result in price changes
for all pharmaceutical consumers.

Drug makers would be not only unwilling, but also primarily
unable, to extend below-average prices to such a large group.
Medicare's prices will invariably approach the average market
prices, and seeking to force prices lower will be nearly impossible
unless significant costs could be shifted onto others. Analyzing
the possibility of extending federal prices to Medicare, the
Government Accountability Office concluded:

Mandating that federal prices for outpatient prescription drugs
be extended to a large group of purchasers, such as Medicare
beneficiaries, could lower the prices they pay but raise prices for
others. Such price changes could occur because drug manufacturers
would be required to charge beneficiaries and federal purchasers
the same prices. To protect their revenues, manufacturers could
raise prices for federal purchasers. Furthermore, because federal
prices are generally based on prices paid by nonfederal purchasers,
manufacturers would have to raise prices to these purchasers in
order to raise the federal prices.[14]

Extending federal prices to Medicare-and especially any of the
additional price concessions received by the VA-would result in
significant cost-shifting, as experienced after the enactment of
the Medicaid rebate program in 1990[15]. With pharmaceutical companies having to
look elsewhere for returns on their sizeable investments, they
would be forced to charge higher prices to non-federal purchasers,
including private health plans and other federal purchasers
(because their prices are based on non-federal prices). Thus,
government interference in Medicare pricing would likely accelerate
the growth of drug prices for the entire country.

Moreover, closing off the market to uncooperative pharmaceutical
companies, especially those offering high priced breakthrough
drugs, or otherwise restricting access to a wide range of
prescription drugs, would be no small political feat. Denying the
Medicare population access to new drugs in the name of cost control
could be a formidable political challenge for Congress and Medicare
officials. After all, for seniors and the disabled, there is no
realistic alternative to Medicare; in that sense they are quite
unlike VA enrollees. But if the government were ambitious enough to
deny or restrict market access to drugs-for both drug makers and
patients-service utilization and costs in other parts of Medicare
would increase, and beneficiaries who seek drugs elsewhere would
face a greater financial burden.

The High Cost of Government
Interference

Nonetheless, many in Congress advocate imposing the VA model on
Medicare. Yet, if Congress fixes prices in Medicare and establishes
a restrictive national formulary, the program would be less
responsive to the diverse and ever-changing needs of beneficiaries
and far more open to congressional budgetary pressures, such as the
annual process of political gaming and ferocious lobbying by
special interests. In addition, there would be a chain of other
costs: billions of dollars in averted research and development
expenditures by drug makers, forgone investment in an untold number
of new drugs, and the considerable loss of valuable research and
science jobs.

Medicare Part D circumvents these problems with its private
competition framework and allows Medicare beneficiaries to choose
the plan with the formulary that best meets their needs and
preferences and to switch plans each year during open season. These
competing private plans negotiate for lower prices with drug makers
through formularies designed by experts. As a result, private plans
face intense competition in the market, where there is pressure to
be responsive to beneficiaries who wish to maintain access to a
broad array of drugs at low prices. Medicare Part D does this while
functioning within an open, private system of health care providers
that allows seniors their choice of private doctors and hospitals,
drug plans, and pharmacies.

If the VA's pricing practices were extended to a large market
like Medicare, it would probably not lower drug prices or control
costs. In fact, establishing a VA model in Medicare would probably
have the opposite effect. The VA may indeed be adequate for the
small market of veterans, who tend to have other drug coverage
options. But as a model, it could not easily be applied to Medicare
and would prove inadequate to meet the needs of the rapidly growing
Medicare population which, now at least, enjoys the tangible
benefits of a responsive, market-based system of consumer choice
and competition.

Greg D'Angelo is Research Assistant
in the Center for Health Policy Studies at The Heritage
Foundation.